1997 (1) TMI 49 - HC - Income Tax

Summary

Issues Involved:
1. Whether the sum of Rs. 2,50,348 paid by the assessee to its retiring partners was an allowable expenditure under section 37 of the Income-tax Act, 1961.

Issue-Wise Detailed Analysis:

1. Allowability of Expenditure Under Section 37 of the Income-tax Act, 1961:
The core issue in the case was whether the sum of Rs. 2,50,348 paid by the assessee to its retiring partners could be considered an allowable expenditure under section 37 of the Income-tax Act, 1961. The assessee, an unregistered firm engaged in manufacturing malt for brewery units, claimed this expenditure as business-related, arguing it was necessary to remove inefficient partners for the efficient running of the business. The Income-tax Officer and the Commissioner of Income-tax (Appeals) disallowed the expenditure, viewing it as a capital expenditure for acquiring proprietary rights in the business. The Tribunal, however, allowed the expenditure, reasoning that the payments were made to facilitate the business by removing inefficient partners and thus were revenue in nature.

Tribunal's Reasoning:
The Tribunal concluded that since the firm was under huge losses, nothing was payable to the outgoing partners towards their capital in the firm. Therefore, the compensation paid by the continuing partners was essentially an expenditure incurred in the course of business and for the purpose of business. The Tribunal emphasized that the payments were made to remove the disadvantageous relationship at the behest of the bankers and were not for acquiring an enduring benefit.

Revenue's Argument:
The Revenue contended that the payments were made to acquire the rights of the retiring partners in the assets of the firm and thus were capital in nature. The counsel for the Revenue argued that the payments described as compensation were in fact made in lieu of the rights of the retiring partners and were not related to running the business.

Assessee's Argument:
The assessee argued that the expenses were incurred for the efficient running of the business because the management of one partner resulted in losses. The firm had incurred huge losses, and nothing was payable to the outgoing partners on their account. Therefore, the expenses should be treated as revenue expenditure.

Court's Analysis:
The court rejected the assessee's contention that a firm assessed as an independent taxable entity should not be viewed in the context of the Partnership Act. The court noted that the retirement of a partner affects the constitution of the firm and must be viewed in light of the Partnership Act, which governs the rights and duties of partners. The court emphasized that the payments made to the retiring partners were in lieu of their rights, title, and interest in the partnership, including its assets and goodwill. The court found that the payments were not related to the running of the business but were for acquiring the rights of the outgoing partners.

Relevant Case Law:
The court referred to the decision of the Andhra Pradesh High Court in CIT v. Puran Das Ranchoddas and Sons [1988] 169 ITR 480, where it was held that payments made to outgoing partners under a deed of dissolution towards goodwill were capital expenditures. Similarly, in General Auto Parts Co. v. CIT [1981] 128 ITR 519 (Delhi), the Delhi High Court held that payments made by continuing partners to acquire the rights of retiring partners in the assets of the firm were capital expenditures.

Conclusion:
The court concluded that the payments made to the retiring partners were in lieu of their rights in the partnership and were not deductible as revenue expenditure. The question referred to the court was answered in the negative, in favor of the Revenue and against the assessee. The Tribunal's decision was found to be erroneous, and the payments were determined to be capital in nature, not allowable under section 37 of the Income-tax Act, 1961. The reference was disposed of with no order as to costs.

Separate Judgment:
RAJESH BALIA J. concurred with the conclusion and added that the payment to the retiring partners was a settlement of accounts and not an expenditure incurred by the firm for business purposes. He emphasized that the payment was for the severance of the relationship between partners and not for the running of the business. The reconstituted firm came into existence only after the settlement, and the payment was a return of the outgoing partners' share in the firm's assets.